The BIS (Bank for International Settlements), an international organization promoting cooperation among the world’s central banks, published its annual report on June 28. The BIS is always pointing out the need for improvements in the global financial system, but this year their language was stronger than usual. They criticized debt levels in emerging and developed markets, the malaise in the global economy, low productivity growth, and the lack of room to maneuver in economic policy. They see some improvements in some areas and some deterioration in others. They also point out that all of these problems have become perceived as the “new normal.”
We have long been saying similar things, so we’re interested to see a staid institution like the BIS say that “short-term gains risk being bought at the cost of long-term pain,” and that global economic rebalancing must take place on a national and global level.
Further, BIS analysts point out that “one essential element of this rebalancing will be to rely more on structural change so as to abandon the debt-fueled growth model that has acted as a political and social substitute for productivity enhancing reforms.” They go on to say that oil prices at present lows are a not-to-be-missed opportunity to abandon debt-fueled growth and the illusionary prosperity that increasing debt creates, and instead pursue enhanced productivity in order to raise the real standard of living.
Interest rates must rise in the developed world in order to handle the next crisis. As we have all seen over the past few years, lowering interest rates has been a primary tool of central banks in dealing with the 2008 crisis and its aftermath. If rates are still near zero during the onset of some future crisis, the interest-rate tool will simply not be available.
The BIS is reminding all of us that excessive leverage exists throughout the world, in both developing and developed countries, and excessive leverage will end in tears. As any student of economic and financial history knows, it leads to a set of very unpleasant effects when it all comes tumbling down.
Here at GIM, we are letting our readers know that excessive leverage is a major global issue for the future. For 45 years, we have watched interest rates and credit markets as a leading indicator for stock market problems. Our primary diagnostic tool for avoiding crashes, beginning in the 1970s, has been to monitor changes in credit markets and interest rates -- and it is still our primary diagnostic tool.
Historically, crises of over-leverage have had similar solutions, and the solutions have been painful. Defaulting countries experience higher income and consumption taxes; a lower standard of living; lower salaries and wages; lower pensions; difficulty in achieving enough financial stability for retirement; fewer opportunities travel, vacation, and to enjoy relaxation and entertainment.
In summary, what lies ahead for the over-indebted developed world is more work, less freedom to choose, less leisure, and less pay. The question is when.
For now, credit markets and interest rates point to higher stock prices in some regions of the world and lower in others. We are focusing on growth areas. The ongoing crisis in Greece and the emerging crisis in Puerto Rico are just the harbingers of more problems to come. We expect that within two or three years, new cracks may develop in the global financial system. We will be prepared.
In the short term, hold more cash as the European and Asian markets have a moderate correction. Over the coming days and weeks, we will use dips to buy quality stocks in the U.S., China, and Japan. In our view, all of these markets are attractive for the next couple of years, but the way to prosper is to buy dips.
Investment implications: Much of the world, developed and developing, is laboring under the weight of excessive public and private debt leverage. Ultimately, this over-leverage will be resolved by some combination of crisis and structural reform, both of which will be difficult. Our chief barometer for spotting the arrival of this “crunch time” for the global financial system is the credit-market and interest-rate environment. The U.S., China, and Japan remain attractive. On dips, we continue to be buyers of these markets, and of strong sectors and companies within them.
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